Thanks to stiff competition in the increasingly crowded ETF
marketplace, fund sponsors have begun lowering the
expense ratios on many of their most popular products.

Most investors understand that expense ratios can make a
big difference in the overall performance of a fund, especially
over the long term. For example, $25,000 invested in a
traditional, actively managed mutual fund that carries an
expense ratio of 1.5 percent will grow to $163,000 in 35 years,
assuming a 7 percent annual return. That $25,000 will grow to
$227,000 over the same time period in an ETF that charges a
fee of 50 basis points. That extra 1 percent in expenses
ultimately curtails an additional 28 percent in potential gains.

The good news for ETF investors is that fund sponsors
have begun chipping away at expense ratios. A relative
latecomer to the ETF marketplace, Vanguard has made up for
lost time by moving aggressively to position itself as the
sponsor to beat on investor costs. The company currently
offers 16 funds with annual fees of 15 basis points or less. Its
domestic Large-Cap ETF (NYSEARCA:VV) and Total Stock Market ETF
(NYSEARCA:VTI) carry rock-bottom expense ratios of just seven basis
points.

There is even some indication that the traditional, actively
managed mutual fund world is responding to the pricing
pressure from ETFs. Fidelity’s family of Spartan funds has
expense ratios comparable to Vanguard’s low-fee ETFs.

Investors traditionally pay more for international or
targeted sector exposure. While this remains true at Vanguard,
the premium is fairly modest. Domestic sector funds charge 12
to 22 basis points in annual expenses, and the priciest
international ETF, the Emerging Markets Fund (NYSEARCA:VWO), will
set investors back 30 basis points.

Vanguard has almost certainly put pressure on fund giant
Barclays, the sponsor of the iShares line of ETFs, to lower its
fees. In fact, Vanguard recently changed VWO’s benchmark to
the MSCI Emerging Markets Index, the same index that
underlies the iShares MSCI Emerging Markets Index Fund
(NYSEARCA:EEM), a behemoth with nearly $26 billion in assets under
management as of late October. The iShares fund, however,
charges an annual expense ratio of 0.75 percent. Earlier this
year, iShares lowered the annual fees on most of its
international ETFs by four to five basis points. Interestingly,
the only fund it didn’t make any changes to was EEM.

But iShares may have a good reason for keeping EEM’s
fees where they are. As the ETF giant likes to point out, the
expense ratio is an important consideration, but it isn’t the
only cost investors should consider when choosing between
two similar — or in the case of VWO and EEM – virtually
identical ETFs. Implicit costs, such as trading and market
impact costs and the fund’s tracking error relative to its
benchmark, can also significantly undermine the long-term
performance of a portfolio. ETF investors who trade
frequently should consider these implicit costs of owning a
fund as well as annual expense ratios before writing that
check.

So how can investors get a bead on the implicit costs of
owning an ETF? Keep in mind that there are essentially two
types of ETF liquidity. The first is the ease with which
investors can buy and sell their shares on the secondary
market, and the second is the liquidity provided by the ETF
creation and redemption process. Both types of liquidity
can have a direct impact on how quickly, and at what
price, investors can execute their trades.

Lehman Brothers did a study of how VWO and EEM
performed during the volatile trading of February 27, 2007,
when fears of intervention by the Chinese government in
that country’s soaring stock market triggered a 9 percent
sell-off in Shanghai. Markets across the globe reacted to the
pullback in China, and the Dow closed that session down
more than 400 points. During trading that day, EEM proved
to be the more liquid of the two funds, occasionally trading
at twice the volume of VWO. EEM also maintained a
tighter bid/ask spread (never wider than around three basis
points) than did VWO.

The upshot is that expense ratios only tell part of the
total cost story. Investors who trade their ETF portfolios
frequently may find that lower implicit costs justify a higher
annual fee in certain funds.

Some investment professionals think that investor
focus on fees is misplaced, particularly when it comes to
ETFs. The priciest exchange-traded funds carry expense
ratios of around 1 percent, and these are typically niche
products and not portfolio mainstays such as the inverse and
leveraged line of funds from ProShares, with annual
expenses of 0.95 percent.

The most important consideration when choosing an
ETF, then, is not costs — either expressed annual fees or the
implicit costs of ownership — but whether the fund’s
underlying basket of securities is going to be a profitable
portfolio addition.